Brighter future for UK equity income

The underperformance of the UK equity income sector has started to look entrenched. Despite some of the UK's most respected fund managers predicting that the large cap, dividend-rich companies that characterise the sector are due for a resurgence, any recovery has been conspicuously absent and the sector still lags the more growth focused UK All Companies sector over all recent time periods.

However, the sector received a boost from analysis by Capita Registrars (see Bloomberg) that dividends are likely to rise by 11.5% in 2011 after two years of falling payouts. Dividends had been hit first by the economic crisis and then by the Gulf of Mexico crisis for BP, then the largest dividend payer in the FTSE 100.

Having outperformed from 2000 to 2006, many began to read a structural advantage into the equity income sector. The theory went that equity income should naturally outperform over the long-term because it imposed a natural valuation discipline. It forced investors to buy when valuations were low and sell out as they moved higher.

In theory, this structural advantage should have endured through the economic crisis and beyond. As it was, equity income portfolios were stuffed full of high-yielding banks and other financial stocks and were hit hard by their collapse. It was then hit again by the readiness of corporates to cut dividends and then again by the troubles at BP.

The equity income sector is still behind the UK All Companies sector over one, three and five years, having delivered 16.8%, 45.5% and 11.5%, compared to 19.7%, 57% and 15.2%. The sector has occupied an investment hinterland when it neither offered growth when the market wanted growth, nor defensive qualities when they were needed.

Now the sector has some genuine tailwinds and many experts are predicting a brighter future as this article from Investment Week demonstrates. In it, Dan Roberts, manager of Gartmore UK Equity Income fund, says: "We would expect a good level of market dividend growth which, alongside the healthy initial yields on offer, provides an attractive proposition for potential investors."

But will it really be different this time? Fund managers have been predicting a turnaround in sentiment towards large cap, dividend-paying equities for several years and none has yet materialised. These companies may be cheap, but they have remained cheap for some time and surely they may continue to do so?

They may, of course, but there are signs that market sentiment is turning. Vodafone, for example, and Royal Dutch Shell, have both seen a significant run of performance as markets have wised up to their value. Just because the story hasn't worked out before does not mean that it will not work out this time. The value of dividends in an income-hungry environment is likely to emerge eventually.